Buy Sell Agreement

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We talk a lot about protecting our business, but what about protecting our family’s interest in the business?

If your company has more than one shareholder, it’s important to think about what would happen if one of the shareholders (yourself included) was to pass away.

There are two side to look at this from. The first is where one of the other shareholders loses their life, and the other is where you lose your own life.

We’ll look at each scenario individually.

Another shareholder dies

If one of the other shareholders was to die, presumably their wife, husband or children would inherit their share of the business.

This may not bother some people, but how would you feel if your business partner’s wife or children suddenly had equal say in how your business was run?

For many business owners this would not be an enjoyable situation.

It may not be an enjoyable situation for the people who have inherited the business either. Perhaps they have no interest in the business and would prefer to sell their shareholding.

This would be all good and well if you could agree on a price and have access to sufficient funds to complete the transaction, but this is not always the case.

What if you could not access the funds, and instead the family sold their shareholding to a third party? Again, you may not have any control over who becomes your new business partner.

This entire situation can be managed by having a buy-sell agreement in place along with the appropriate insurance to fund the agreement.

Before we go into the details of the buy-sell agreement we’ll take a look at the second scenario, where you are the shareholder who passes away.

You as a shareholder dies

In the event that you die as a shareholder, your beneficiaries would end up with your shareholding. This could be your wife, husband, children or whoever you have nominated.

If your family have no interest in continuing with the business, the best option would likely be for them to sell the business to the surviving shareholders.

This way your family would receive the financial benefits of your years of hard work without being burdened with a shareholding they don’t want.

But what if the surviving shareholders cannot raise sufficient funds to complete the buyout, or cannot agree on a fair price for your family’s share of the business?

Remember that you’re no longer around, so you can’t be there to fight for what your family deserves.

Again, a buy-sell agreement can manage this process so that your family receives a fair financial settlement for your share of the company.

What is a buy-sell agreement?

A buy-sell agreement, along with the associated insurance policies, helps to ensure that if a shareholder dies there will be sufficient funds to payout their family in exchange for their shares.

Ultimately this should create a win-win situation for all parties involved.

The shareholder’s family receives fair compensation for their share of the business, and the remaining shareholders do not have to worry about new shareholders coming into the business.

Case study

Let’s take a look at how it works in practice. To do so we’ll use the example of Mark and Daniel who run a business consulting firm.

Mark and Daniel started the business together, and each own 50% of the shares in the company.

They both have young families, and although the business has been quite successful they both have sizeable mortgages on their homes.

Mark and Daniel had a buy-sell agreement in place, and the agreement valued the firm at $1,500,000 based on traditional valuation methods.

Based on the valuation of $1.5 million, the agreement was supported by life insurance policies of $750,000 for both Mark and Daniel.

Sadly Daniel was killed suddenly in a vehicle accident on the way to work one Tuesday.

The buy-sell agreement was triggered, and as a result Daniel’s family received a payment of $750,000 from the life insurance policy. This payment covered their share of the business.

Mark received Daniel’s shareholding, leaving him with 100% ownership of the business despite not having to fund the $750,000 purchase price that would have been required without insurance.

So the end result was that Daniel’s family received a fair payment for their share of the business, and Mark gained full ownership of the firm.

The role of life insurance

Alongside the agreement itself, life insurance is the key to making the arrangement work.

Without the insurance component the surviving shareholders would still have to fund the purchase price, which is not always possible, especially with such short notice.

Life insurance means that the process can run smoothly without any of the parties involved suffering any additional financial hardship.

Whilst life insurance isn’t traditionally thought of as a form of business insurance, when used in conjunction with a buy-sell agreement it can certainly provide benefits for the business and its shareholders.

Structuring the agreement

There are a number of different ways to structure the agreement, particularly when it comes to the ownership of the life insurance policies.

The three main structures are as follows:

  • Self-ownership: Each shareholder owns their own policy
  • Cross-ownership: Each shareholder owns policies covering the other shareholders
  • Corporate ownership: The company owns policies covering each shareholder

There are also options which involve a trust owning the insurance policies, or even each shareholders’ superannuation fund owning the policies.

Which ownership structure is best for you and your fellow shareholders really depends on your own company structure and your needs and objectives.

The best option is to seek advice from suitably qualified professionals who have experience with buy-sell agreements and insurance.

Advice warning

There can be major tax implications when it comes to buy-sell agreements.

If the agreements and contracts are not worded correctly in the first place, some or all parties could end up with large and unexpected tax liabilities.

For this reason it is important to seek professional advice when setting up such an agreement.

Ideally there should be three parties involved on the advice side. This should include a financial planner, a solicitor and your accountant.

Together they will be able to structure the agreement and the insurance policies to ensure a smooth transaction should the agreement ever be triggered.

For the benefit of yourself and your family, as well as your fellow shareholders and their families, having a properly structured buy-sell agreement in place should be a vital part of your business succession planning.